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1 Discussion Paper 2/2012 The Politics of Central Banking and Implications for Regulatory Reform in Sub-Saharan Africa The Cases of Kenya, Nigeria and Uganda Florence Dafe

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3 The politics of central banking and implications for regulatory reform in sub-saharan Africa The cases of Kenya, Nigeria and Uganda Florence Dafe This Discussion Paper is part of a wider study on the political economy of financial reforms within the research project Making Finance Work for Africa commissioned by the Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ). The views expressed in this paper are those of the author alone and do not necessarily represent the views of GIZ. Bonn 2012

4 Discussion Paper / Deutsches Institut für Entwicklungspolitik ISSN Die Deutsche Nationalbibliothek verzeichnet diese Publikation in der Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im Internet über abrufbar. The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data is available in the Internet at ISBN: Florence Dafe is a political economist and works as a researcher in the Department World Economy and Development Financing at the German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE). Her research interests are the political economy of financial system development and the role of the state in the governance of financial markets. Deutsches Institut für Entwicklungspolitik ggmbh Tulpenfeld 6, Bonn +49 (0) (0)

5 Acknowledgements A number of people from the GIZ programme Promoting Financial Sector Dialogue in Africa: Making Finance Work for Africa and the GIZ financial sector development programmes in Nigeria and Uganda provided generous assistance and feedback during the preparation of this study. I would particularly like to thank Gabriela Braun, Robin Hofmeister and Saliya Kanathigoda. Special thanks are also due to Kathrin Berensmann, Birgit Schmitz and Peter Wolff for comments on an earlier draft and to Mick Moore, Stephen Spratt and Ulrich Volz for their consistent guidance and support for my larger research project on the comparative political economy of central banking in developing countries. Finally, while in the field, I benefited from the insights of a number of individuals, and I am very grateful to those who took the time to share some of their knowledge with me. Bonn, February 2012 Florence Dafe

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7 Abstract As regulators, central banks can play a stabilising role, using prudential regulation to ensure financial system stability, and a transformative role, using regulation to promote financial system development and so encourage financial deepening and inclusion. While there are strong arguments for central banks seeking to strike a balance between their stabilising and transformative roles in financial regulation, African central banks have had difficulties in this respect. This paper presents case studies from Nigeria, Uganda and Kenya that show how central banks have historically tended to emphasise one role rather than the other. Reforms that seek to improve the balance between the stabilising and transformative roles of central banks in financial regulation are difficult because interest groups with the power to shape central bank behaviour tend to prefer the regulatory status quo and may try to capture regulatory reform processes. As facilitators of financial reform processes in many African countries, donors should systematically address the challenges posed by regulatory capture with a view to maximising the effectiveness of their support for regulatory reforms.

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9 Contents Abbreviations 1 Introduction 1 2 Research design and methodology 2 3 Striking a balance between stabilization and transformation: central 6 bank policy trajectories in Nigeria, Uganda and Kenya 3.1 Continuity in the transformative mandate: the Central Bank of Nigeria Transformation towards stabilisation: the Bank of Uganda In search of a balance between stabilization and transformation: the Central Bank of Kenya 17 4 Challenging reformers: the power of groups with an interest 20 in the status quo 4.1 Financial needs and central bank behaviour Financial needs and incentives for regulatory capture 24 5 Supporting reforms of financial regulation in contexts of capture Making information available Promoting central bank transparency and openness Strengthening the engagement of interest groups with a stake in change Using political economy analysis in programme design 32 6 Conclusion 33 Bibliography 35

13 The politics of central banking and implications for regulatory reform in sub-saharan Africa 1 Introduction Central banks are key institutions to govern finance and the economy more generally. They may play a stabilising role by using monetary policy to ensure price stability and prudential regulation to ensure the stability of the financial system. They may also play a transformative role and use their regulatory powers to promote the development of a financial system that focuses on channelling financial resources into productive investment by actively encouraging financial deepening and inclusion. In the aftermath of the global financial crisis, there has been an intense debate in African 1 countries on the direction promoting stability, economic transformation or both their central banks as regulators should be taking. Advocates of a stabilising role seem to be dominating the discussion about the future role of central banks after what is deemed to have been the worst financial crisis ever. And yet a view emerging among African policymakers and development practitioners is that central banks should play a role that goes beyond safeguarding monetary and financial stability and seeks to develop a responsible financial sector, particularly through regulation that provides an enabling environment for the outreach of financial services (De la Torre et al. 2007; CGAP 2011; CGAP 2010; Beck et al. 2011). This view is based on two important arguments. The first is that, by playing a transformative role, central banks can reduce risk in the financial sector: while prudential regulation may go some way towards precluding banking distress, the recurrent nature of financial crises around the world suggests that such regulation is not enough to prevent crises (New Economics Foundation 2009). From this perspective, prudential regulation should be complemented by measures that seek to encourage a different structure for the financial system. As regulators, central banks are best placed to create an institutional environment that supports the transformation to a financial system which diversifies risk by providing a broad range of financial services for different customers rather than engaging in a narrow range of short-term, possibly speculative activities (Hannig / Jansen 2010; Hawkins 2011). The second argument is that, where central banks stabilising and transformative roles complement each other, this may help to ensure that financial systems fulfil their original purpose of mobilising long-term capital and allocating it to the most productive sectors, firms and individuals in the economy (Epstein 2005; Epstein 2006; Maxfield 1990). Although these arguments have convinced many policy-makers that central banks should seek to balance their stabilising role with a more transformative role, African countries have had difficulty striking such a balance and reforming financial regulation accordingly. The purpose of this paper is twofold: first, to illustrate and explain the political challenges faced by African central banks in striking a better balance between their stabilising and transformative roles in financial regulation; second, to recommend to donors ways of making their support for financial regulatory reform more effective by addressing these political challenges. 1 Unless otherwise stated, the term Africa in this paper refers to sub-saharan Africa. German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 1

14 Florence Dafe This paper adopts a political economy approach to explain the variation of central bank roles across Africa and their stickiness over time. What little research has been conducted into central banking in Africa has largely been technical and so has little to say about the political challenges to financial regulatory reform. The paper therefore builds on both political economy theory and data derived from interviews with key political decisionmakers, donors and researchers in three African countries, Nigeria, Uganda and Kenya. Both theory and the findings of field research in these three countries suggest that the financial needs of powerful interest groups have shaped their central bank policies, and that such groups seek to maintain the status quo in financial regulation. Reforms of financial regulation that aim at improving the balance between the stabilising and transformative roles of central banks are difficult because these interest groups have an incentive to capture regulatory reform processes. Based on these insights, the paper recommends that donors, as facilitators of financial reform processes in Africa, should systematically address the challenges posed by regulatory capture with a view to improving their support for regulatory reforms. The remainder of the paper is divided into five sections: section 2 outlines the research design and methodological issues to provide a background to the context in which the research has taken place. Section 3 illustrates, from a historical perspective, the extent to which African countries have managed to strike a balance between the stabilising and transformative roles of central banks in financial regulation, taking Nigeria, Uganda and Kenya as examples. Section 4 explains the ways in which powerful interest groups may pose a challenge to reforms that seek to improve the balance between the stabilising and transformative roles of central banks in financial regulation. Section 5 puts forward a number of recommendations for improving the effectiveness of financial regulatory reform where there is a risk of capture. Section 6 concludes the paper. 2 Research design and methodology As this is the first phase of a larger research project on the comparative political economy of central banking in Africa, this paper focuses primarily on setting the scene by illustrating the political challenges to reforms of financial regulation aimed at improving the balance between the stabilising and transformative roles of central banks. It is less concerned with developing the underlying theory. In particular, it places less emphasis on reviewing the relevant theory, giving precise definitions of terms and hypotheses, testing propositions against alternative explanations or making generalisable claims. Rather, it seems important in the first phase of the multi-country study to set the scene by illustrating and explaining the political challenges to regulatory reforms aimed at improving financial stability or financial deepening and inclusion, taking three African countries as examples. As a result, the conclusions drawn remain locally specific. The decision not to provide precise definitions of terms at the present stage is also apparent from the broad sense in which the terms stabilising and transformative are used to describe the roles of central banks in financial regulation. A central bank is considered to play a stabilising role where it uses prudential regulation to improve financial system sta- 2 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)

15 The politics of central banking and implications for regulatory reform in sub-saharan Africa bility. The extent to which a central bank plays this stabilising role is reflected in the stringency of prudential regulation. Prudential policies typically seek to build up sufficient capital in financial institutions for them to cover expected and unexpected losses, achieve or maintain a manageable level of non-performing loans, address maturity or currency mismatches and strengthen the powers of financial supervisors. In contrast, a central bank is considered to play a transformative role where it uses regulation to encourage financial deepening and inclusion with a view to promoting financial intermediation, i.e. an increase in the level of financial resources that the financial sector channels into productive investment. The extent to which a central bank plays a transformative role is reflected in how activist it is in formulating regulation to encourage financial deepening and inclusion. In developing countries, central banks trying to play a transformative role typically use a variety of regulatory policies to promote better and more efficient access to financial services for un- or underserved segments of the private sector, such as small and mediumsized enterprises (SMEs), micro-entrepreneurs and agriculture (Soludo 2009, 12; Epstein 2006; CGAP 2010, 16-22; Claessens et al. 2009). Thus the distinction made in this paper between the stabilising and transformative roles played by central banks serves to show how they occupy different positions on a spectrum of the stringency of prudential regulation and on a spectrum of regulatory activism in pursuit of financial deepening and inclusion. Besides financial regulations, strategy documents and technical units within central banks mandated to promote financial stability or financial deepening and inclusion indicate how far they pursue their transformative and stabilising roles (Čihák 2010; Cukierman et al. 1992; CGAP 2010). The distinction made between a central bank s stabilising and transformative roles is therefore not binary: a central bank can play both roles at the same time, to varying degrees. However, there are not only synergies but also trade-offs between the two roles in financial regulation, at least in the short and medium term. Table 1 gives some examples of regulatory policies that central banks in developing countries have been pursuing, with varying levels of success, to improve financial stability and/or financial intermediation. In some cases, the regulatory policies adopted to promote one objective also help the other to be achieved. Regulation designed to develop credit reporting through credit bureaus, to take one example, is likely to have the effect of directly promoting both financial stability and financial intermediation. In other cases, regulatory policies pursued to achieve one objective may pose risks to achieving the other objective. For instance, spurring competition through the lowering of barriers to entry may have a positive effect on financial intermediation, but pose a risk to financial stability if regulators do not address the trade-off in the design of policies. The roles that central banks play as they seek to promote financial intermediation may vary in activism from providing a framework for financial deepening and inclusion that also helps to improve financial stability to providing a framework for financial deepening and inclusion that so encourages financial market activities that stability is put at risk. German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 3

17 The politics of central banking and implications for regulatory reform in sub-saharan Africa and transformative roles of central banks may operate in both directions: on the one hand, they seek to detect deficiencies in the regulatory framework designed to promote financial deepening and inclusion and so to improve it that it takes better account of risks to financial stability. On the other hand, these reforms seek to detect deficiencies in prudential regulation and so to improve it that it takes better account of risks to financial intermediation. The specific positions that central banks occupy along the spectra largely reflect the views held on how financial and economic systems work and political economy factors. For instance, the fact that a central bank emphasises its stabilising rather than its transformative role does not necessarily indicate that the government or central bankers are indifferent to growth and development. Rather, it may indicate that they regard the assurance of financial stability as the best way to generate sustainable growth. From this perspective, proactive attempts to generate development are likely to fail and damage long-term growth prospects. Alternatively, the view held may be that ensuring financial stability will not lead to a successful, market-led development process, but that that process needs to be encouraged by more activist financial development policies. Thus central banks in different countries may be equally committed to promoting economic development and yet behave very differently because they have different models of economic development. Taking three country cases, this paper illustrates the diversity of positions occupied by central banks along the spectra of the stringency of prudential regulation and of activism in regulation aimed at financial deepening and inclusion. It also demonstrates how political and economic factors combine to encourage the creation and maintenance of a central bank that reflects a particular model of how economies work and occupies a particular position on the spectrum. Nigeria, Uganda and Kenya have been selected as the country cases by the diverse case method (Seawright / Gerring 2008, ). Based on this method, the research identified a set of cases of sub-saharan African countries that encompasses a wide range of values with respect to two proposed key explanatory variables, namely the level of development of the domestic financial sector and the sources of public finance. Nigeria was chosen because of the little research so far conducted on its central bank policy despite the importance of the economic and political weight the country carries in Africa. Nigeria does not have a well developed financial system, considering the level of its national income: financial intermediation is limited because the financial system is not well diversified, but focuses on the higher end of the market and offers a limited range of products (Sanusi 2010). Moreover, the unsound conduct of banks has repeatedly caused banking distress in past decades. Oil is the major source of revenue for the Government of Nigeria, because the non-oil productive sector is weakly developed. Nigeria therefore allows to explore the effect that natural resource dependence has on central bank behaviour. Uganda and Kenya were chosen because they differ from Nigeria where the proposed key explanatory variables of financial development and sources of public finance are concerned. Uganda s financial sector is among the least developed in Africa in terms of size, diversity, efficiency and financial intermediation (Egesa 2010; Beck / Hesse 2009, 195; Kasekende 2010a, 74-76). The Government of Uganda relies heavily on foreign aid to finance government expenditure. Taxes have yet to become the single most important German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 5

18 Florence Dafe source of government revenue: the productive sectors are weakly developed, as is evident from the missing middle, with a small number of large enterprises, a large number of micro-enterprises and the prevalence of subsistence agriculture. In contrast, the financial system in Kenya is among the most developed in Africa in terms of diversity, size and financial intermediation. The Government of Kenya relies heavily on taxation as a source of revenue, since the productive sectors in Kenya are relatively well developed (African Economic Outlook 2011a). Kenya compares favourably with other African economies with respect to the commercialisation of agriculture and the diversity of the size of firms in the productive sector. As the financial systems in Nigeria, Uganda and Kenya are still, as elsewhere in Africa, very much bank-based, this research explores the political economy of financial regulation focusing primarily on the regulation of banking services. Methodologically, the research is based on a combination of secondary literature, quantitative data and extensive interviews with policy-makers, donors and researchers in Nigeria, Uganda and Kenya. Secondary literature on African political economy and more technical literature on monetary and financial policy in addition to literature on the political economy of finance have been studied. The quantitative data present a detailed picture of the macroeconomic and financial development in the three case study countries over time. The data indicate that a combination of economic and political factors may pose challenges to regulatory reform. The interviews are a key research input because they have helped to ensure that the story told reflects an assessment of what those involved in financial reform processes consider to be key success factors for and challenges to effective regulatory reform. 3 Striking a balance between stabilisation and transformation: central bank policy trajectories in Nigeria, Uganda and Kenya This section identifies the challenges African countries face where they seek to reform financial regulation in order to strike a better balance between the stabilising and transformative roles of their central banks. With Nigeria, Uganda and Kenya taken as examples, this section presents historical narratives to illustrate the diversity of the roles played by central banks and to describe how far these countries have sought to strike a balance between the stabilising and transformative roles of their central banks in financial regulation and how far they have succeeded. The historical perspective shows the difficulty of adapting the overall thrust of central bank regulation to changing circumstances, highlighting the path dependency of central banking. 3.1 Continuity in the transformative mandate: the Central Bank of Nigeria When Nigeria became independent in 1960, banks, both foreign and indigenous, played no role in financing the domestic private sector or economic development more generally: Expatriate banks focused on providing banking services for British commercial enterprises and short-term trading activities rather than mobilising long-term capital for development 6 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)

19 The politics of central banking and implications for regulatory reform in sub-saharan Africa and the growth of domestic business (Brownbridge 1998c, 106). As the indigenous banking system was weakly developed and in financial distress at the time of independence (Uche 1997, 224), it was in no position to finance Nigeria s development needs. After independence, the Central Bank of Nigeria (CBN) therefore focused increasingly on funding government financing needs and providing financial support for a weakly developed banking sector. Indeed, strengthening Nigerian banks and mobilising capital had been the key objectives of the CBN s establishment in 1958 (Uche 1997). From the 1970s in particular, economic aspirations motivated developmental central bank policies that sought to influence the allocation of financial resources through extensive regulation of the banking sector. Allocative controls, such as interest rate controls and the direction of credit to development priority sectors and parastatal enterprises, rather than prudential controls, became the CBN s primary regulatory concerns (Brownbridge 1998c, 106). Until the CBN issued new prudential guidelines in 1991, banking regulation allowed banks, for instance, to conceal the true state of their balance sheets by not requiring them to classify loans according to quality or to make provisions for non-performing loans. Moreover, the CBN pursued an implicit policy of not allowing banks to fail (Brownbridge 1998c, 119): banks with liquidity shortages had recourse to the CBN, regardless of the quality of their management (Nigeria Deposit Insurance Corporation 2009). The CBN further neglected its stabilising role when oil prices fell in the early 1980s, and the government became increasingly unable to control the budget deficit, as Figure 1 shows. Between 1990 and 1994, 86 per cent of the federal budget deficit was financed by the domestic banking system, mainly by the CBN (Brownbridge 1998c, 122; Central Bank of Nigeria 1994, 17). Figure 1: Nigeria, budget deficit/surplus (% of GDP) 20,00 15,00 10,00 5,00 0,00-5,00-10,00-15,00-20,00 Source: CBN, Statistical Bulletin The effects of the central bank policy, which placed the emphasis on the transformative role at the expense of the stabilising role, on the financial sector and the real economy German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 7

20 Florence Dafe were devastating. By the mid-1990s, the Nigerian financial system was in a state of collapse: in 1992, eight banks were insolvent and 45 per cent of bank loans non-performing. In 1995, the CBN classified nearly half of the 81 local banks as distressed (Brownbridge 1998c, 116). Many banks suffered from distress because the requirements relating to lending to risk sectors, mismanagement and fraud, particularly lending to politically well connected, but uncreditworthy individuals, had increased the ratio of non-performing to total loans (Daumont et al. 2004, 38-40). Non-performing loan ratios were also high because higher interest rates stemming from rising inflation (see Figure 2) made it difficult for the real sector to service its debts (Brownbridge 1998c, 117). Nor were banks able to mobilise deposits because negative real interest rates had depressed saving rates and bank failures had destroyed confidence in the banking sector. Thus, after three decades of central bank policy emphasizing a transformative role, banks had become increasingly overdrawn on CBN accounts and dependent on government support for survival. Figure 2: Inflation, consumer prices (annual %) 250,00 200,00 150,00 100,00 50,00 Nigeria Kenya Uganda 0,00-50,00 Source: The World Bank, World Development Indicators The regulatory regime also hurt the real economy. While the oil boom of the 1970s had expanded investment opportunities and strengthened the small indigenous capitalist class, private sector development was stagnant by the mid 1980s: the growing disarray in the wider economy and the weakness of the banking sector starved the real economy of the credit necessary for investment and growth. Figure 3 shows that domestic credit to the private sector as a share of GDP, which had risen between 1970 and 1985, fell between the mid-1980s and mid-1990s. The government s revenue needs, the banking distress and the contraction of credit strengthened the constituency in both the public and the private sector for a transformative central bank that provided subsidised credit, credit guarantees and overdraft facilities for the government and banks. 8 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)

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